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Beware of the Mortgage Prepayment Penalty

By Kira Botkin

mortgage loan agreementApplying for a mortgage can be tricky. There are many things to consider, including something known as a prepayment penalty. A loan with a prepayment penalty may also come with a lower rate and so can seem more attractive.

However, the prepayment penalty will hurt you if you want to refinance or even sell “early.” For this reason, it’s imperative to understand how much the penalty is as well as when and under what circumstances you’d have to pay it. Only then can you make an informed decision regarding whether or not a mortgage with a prepayment penalty is really worth it.

What Is a Mortgage Prepayment Penalty?

A prepayment penalty on a mortgage essentially charges you extra if you pay off the mortgage early. What is considered early, however, will be laid out in your loan documents and therefore must be scrutinized carefully. Not all mortgages come with them, and they are certainly not required.

A prepayment penalty must be paid in order to refinance or sell the house before a certain period of time has elapsed, usually two to three years, although some loans can have them in effect for up to ten years. Also, some prepayment penalties will decline over time, but most don’t.

Moreover, some penalties may only be activated in the case of a refinance and not a home sale. Typically, the penalty is expressed as either a percentage of the loan balance or a certain number of months interest. But either way, these penalties are often high and can be as much as six months’ worth of interest on the loan.

Getting a Prepayment Penalty

A prepayment penalty is part of the loan package, just like the interest rate and any points, and therefore will be laid out with terms and conditions in the loan documents. Lenders can’t add it later without your express permission.

However, some mortgage brokers and loan officers are guilty of less-than-full disclosure, which means it’s up to you to do your due diligence in reviewing the paperwork, regardless of what your broker verbally assures you. In turn, this means that signing loan docs may take a very long time if you haven’t reviewed them beforehand.

Don’t be pressured into reviewing what’s enclosed faster than you’re comfortable with. Sadly, many a prepayment penalty has made it onto people’s loans by somewhat nefarious means. You may even want to have your documents reviewed by an attorney before you sign because once you’ve “agreed” to a prepayment penalty, you can’t get rid of it until it expires or you pay for it.

mortgage house pen

When Might a Prepayment Penalty Help You?

Generally, your loan officer will prefer a mortgage with a prepayment penalty because they are paid a larger commission. However, that isn’t necessarily all bad.

In turn, it allows for a slightly lower interest rate or lower out-of-pocket costs on the loan. For example, if most of your free cash has gone towards a down payment, accepting a loan with a prepayment penalty can be a way for you to get mortgage fees covered and reduce closing costs.

In fact, since some prepayment penalties are for a short period of time, such as six months or a year, you can lower these costs without significantly compromising your ability to sell or refinance the home in the future.

When Can a Prepayment Penalty Hurt You?

While some loans have short-term prepayment penalties, others can be in effect for as long as three to five years. But because many people refinance before then, such penalties can make the process extremely expensive or even impossible.

For example, if interest rates fall three years into your loan, a prepayment penalty could prohibit you from refinancing into a better rate. But let’s say you’ve already gotten an extremely low rate and aren’t concerned about needing to refinance in the future. You still may need to sell. We all know that plans change, so even if you have every intention of staying, you could be transferred in your job or choose to relocate near an ailing family member.

Be assured, if circumstance beyond your control force you to move, your lender will not be inclined to help you out. Some prepayment penalties, known as “soft” prepayment penalties, will only trigger if you refinance and not if you sell. However, many prepayment penalties are considered “hard,” and will trigger upon either event.

Another issue that crops up frequently is whether you can pay extra towards your principal without being assessed the prepayment penalty. Commonly, you are allowed to pay up 20% toward your principal in a single year without being charged.

However, many prepayment penalties are considered “first-dollar” penalties, which means that the first dollar you pay above your required monthly amount will trigger it. Obviously this limits you from paying down your loan any faster than what’s specified in the loan docs, even if you have the money available.

In other words, you may be tied into paying interest that you otherwise wouldn’t have had to pay. For this reason, it’s crucial to verify with your loan officer when you review your loan as well as on the day you sign it, exactly what type of prepayment penalty you have.

How to Avoid Paying a Prepayment Penalty

If you have a prepayment penalty, especially a “hard” one, and want to sell or refinance before the penalty period expires, you probably can’t get out of it. After all, you signed a contract agreeing to pay. Just as your lender can’t unilaterally decide to increase your interest rate, you can’t unilaterally decide to not pay the prepayment penalty when it’s been triggered.

Therefore, you have only a few options available to remove an existing prepayment penalty:

1. Wait for the Penalty to Expire
Find out exactly when your prepayment penalty is going to expire and start shopping for a refinance a few weeks before then. Since your current lender may not be too swift to update your records, it might take some time for the payoff amount on your statement to reflect what you actually owe, sans penalties.

2. Refinance with the Same Lender
This is not always doable, but sometimes if you attempt to refinance with the same lender, they’ll let you out of your current loan without assessing the penalty. Unfortunately, they’ll probably require a prepayment penalty on the new loan as well.

3. Sell the Home If You Have a “Soft” Prepayment Penalty
A penalty isn’t assessed if you carry a “soft” prepayment penalty and you sell your home. However, this type of penalty is not very common. That said, if you wish to sell your home, check your loan documents to see which type of penalty you carry, if any.

4. Pay the Penalty
If you really need to sell or if refinancing would save you a lot of money, run the numbers to see if paying the penalty would actually improve your situation. Just make sure you know exactly how much you have to pay and when, as outlined in your original loan documents. Don’t assume your mortgage broker will know what to do, especially if it’s been a few years since he or she closed the mortgage for you!

Final Word

A mortgage prepayment penalty isn’t fun to deal with, and sadly, comes as a shock to many people who need to sell their home or want to refinance. However, it could make sense for you if you’re trying to reduce your loan costs or get a better interest rate, especially if you have poor credit. Just make sure you understand whether it’s a “hard” or “soft” penalty, when it expires, how much the penalty is, and if you’re able to make extra principal payments without triggering it.

After you’ve acquired all the information, including how much you stand to save by tacking one on, only then can you evaluate whether or not a prepayment penalty makes sense and is worth the risk. Moreover, once you’ve gotten a solid understanding of the benefits and decided whether or not to include one in your loan, make sure the loan docs accurately reflect your understanding before you sign on the dotted line.

Do you have a prepayment penalty on your mortgage loan? If so, has it been worth the risk?

(photo credit: Shutterstock)

Kira Botkin
Kira is a longtime blogger and serial entrepreneur who enjoys gardening, garage sales, and finding stray animals. She lives in Columbus, Ohio, where football is a distinct season, and by day runs a research study for people with multiple sclerosis. She hopes that the MoneyCrashers team can help you achieve your goals and live a great life.

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